As I have briefed you over the last few days, based on a rapidly
changing financial revenue picture, some very strict expenditure measures
are needed, due to a rapidly changing revenue picture, to ensure a
balanced FY 2002 budget.

The need arises from a combination of: 1) a newly estimated $75 million
revenue shortfall in revenues, which is similar to what has been occurring
throughout the country; 2) persistent receivable shortfalls in Medicaid
receivables; and 3) residual spending pressures still to be resolved.

The Office of the Chief Financial Officer (OCFO) estimates that over 80
percent of the $75 million revenue shortfall will have to be met with
savings from District-wide adherence to a very strict expenditure budget
for the remainder of this fiscal year.

This memorandum discusses each of the factors of immediate concern,
those measures the OCFO has already taken and what the OCFO proposes to
ensure a balanced budget. These measures would include freezes on hiring,
overtime, and spending from non-personal services, as well as and
converting eligible "O"-type revenues into unrestricted local
funds.

New Estimate of Local Source Revenue Shortfall

FY 2002 local source revenues are currently expected to be $3,415.7
million,1 or $75 million lower than the
estimate certified on May 6, 2002.

A sudden and steep drop in individual and business income tax
collections occurred in the months of April and May, as reported in the
May 15th and June 17th cash reports (see Attachment
1). The reasons are: 1) a very sharp drop in payments that accompany
individual income tax returns, 2) quarterly payments received for non-wage
income that are notably short in April and May, and 3) a significant
increase in tax refunds paid out. Three measures for gauging individual
income tax collections are resident employment, personal income, and the
behavior of the financial markets. Resident employment — the source of
D.C. withholding payments — continues to be about 1.7% percent below
last year, when we had counted on expected only a 1.0% percent reduction.
Personal income in D.C. is now thought to be growing at a rate of 2.0%
percent, rather than the 2.8% percent earlier anticipated. The financial
markets continue to decline and are now below expected levels, even after
assuming that financial assets were over-valued two years ago.

The May revenue estimate assumed a very strong economic recovery for
the second half of calendar year 2002the year. But since the May estimate,
most economists are adopting a more pessimistic economic outlook for the
second half of calendar the year 2002, due to the recent downward slide in
the stock markets, weaker than expected employment figures, and an
unexpected drop in consumer confidence. A 13.2 percent decrease fall in
overall individual income tax collections for D.C. through the month of
May, combined with the more pessimistic economic outlook, has caused us to
revise the May estimate for FY 2002 individual income tax revenue down by
$130 million for the entire year.

Corporate franchise tax collections also are below the prior estimate
for FY 2002. Refunds of this tax — which reduce net revenue — are $18
million ahead of FY 2001 year-to-date collections,2
jumping to 167 percent ahead of FY 2001 by the end of May (See Attachment
2). Furthermore, since May, the economic outlook has become decidedly more
pessimistic as the stock market has begun continued a downward slide and
growth in corporate profits has failed to recover as initially forecasted.
As a result, we no longer believe the recovery in corporate franchise tax
revenue previously forecasted for the latter part of the fiscal year will
materialize. We have revised the May estimate for the FY 2002 corporate
franchise tax revenue down by $21.7 million..

The neighboring states of Maryland and Virginia, as well as the United
States as a whole, also experienced a drop in revenue. The 13.2 percent
fall in overall individual income tax collections for D.C. through the
month of May is greater than the 6.9 percent decline for Maryland and the
7.7 percent decline for Virginia, but less than the 20.3 percent decline
for the U.S . (See Attachment 1).

The conditions causing this drop are not confined to the District or
the region. Highlights of a report on state revenues3
include:

Personal income tax revenue in January-March 2002 declined by 14.3
percent, the third straight quarter of decline.

Throughout the country, January-April 2002 payments of personal
income tax with returns were off by 26.3 percent.

All but two states reported the January-April collections were below
budgeted targets; the exceptions were Georgia and Virginia.4

The corporate income tax continued its six-quarter-long collapse,
declining by 18.4 percent.

The decline in overall state tax revenue is accelerating even as the
national economy is slowly improving.

After adjusting for tax law changes and inflation, real underlying
state tax revenue declined 9.5 percent, the worst decline in at least
11 years.

This was the third straight quarter of revenue decline for the
states, resulting from the national recession and sharp declines in
stock-market-related income.

While there are some signs of recovery in the general economy,
continued weakness in employment and financial markets is likely to
depress state revenue collections for some time.

The District recently received some important one-time revenues that
help to offset the estimated $130 million individual income tax loss and
$21.7 million corporate income tax loss, in addition to and some losses in
sales and use tax. On a net basis, revenue is now expected to be $75
million less than previously forecast.

Recouping this loss with economic improvements between today and
September 30 is almost impossible. A stunning and sudden rebound in the
stock market might close part of the gap in quarterly declaration
payments, but not all. But aA stunning rebound is not expected. Nor do we
expect sudden growth in resident employment or personal income. None of
these variables is likely to change quickly enough to regain revenue
losses. Indeed, our concerns need to be focused on whether we will lose
additional economic ground and experience larger revenue losses. The $75
million net shortfall is based on slow improvement of the economy across
the summer and, by implication, assumes that D.C. does not have experience
a "double-dip" recession.

It is too early to quantify the effects of this new information for FY
2003. By August, after the next update by CBO the Congressional Budget
Office at the end of July, we will make a new estimate. In the meantime,
we will maintain a close watch on revenues and keep the Mayor and Council
apprised of changes in the projections.

Spending Pressures

In addition to these revenue pressures, the District again faces new
spending pressures in FY 2002. Most pressures are now for items beyond the
District’s control, such as court settlements for past actions. Other
pressures, like the Medicaid reimbursement problem, arise from the
turn-around time needed to implement measures that repair long- standing
problems. Remaining spending pressures for FY 2002 total $301.6 million.
All of the current spending pressures can be met with the balance in the
reserves.

Medicaid and Medicare Receivables Shortfall

Medicaid receivables are expected to experience a total shortfall of
$12.0 million. While Medicaid and Medicare are a federal revenue sources,
the shortfall in collections means that local revenue must be spent to
fill the gap. Since Because Medicaid and Medicare are is an entitlements,
the District is obligated to provide as no legal mechanism to stop
spending for Medicaid- eligible persons with and services.

We continue to be challenged by poor billing infrastructure and
processes. Although we have made tremendous strides during the past
several months in tracking Medicaid revenues bi-weekly, improving the
performance of Maximus and reengineering our billing processes, it appears
that we will have shortfall of $12.0 million at the Department of Mental
Health . This shortfall is precipitated by the fact that they began
billing May 15, 2002, for FY 2002 services. The Department of Mental
Health recently identified the $12.0 million revenue shortfall associated
with Medicaid and Medicare services stemming from: 1) an error in the
calculation of allowable days for Medicaid reimbursement; 2) a correction
to the projected Disproportionate Share payment amount; and 3) recent
changes to federal Medicare reimbursement rules that affect
state-operated, all-inclusive-rate psychiatric hospitals (i.e., St.
Elizabeth Hospital).

We have made significant progress over the past several months in
developing a process for revenue projecting and performance monitoring.
However, it is imperative that we accelerate our efforts to establish
timely, cost-effective revenue generation It is imperative that we devote
the resources and provide the focus to ensure that proper documentation of
services and appropriate billing practices are executed to minimize
revenue shortfalls prospectively.

Based on our meeting with John Koskinen, the Director of the Child and
Family Services Agency (CSFA) Child and Family Services Agency (CFSA) and
the Chief of Operations Chief of Operations at schools, we anticipate no
emerging spending pressures at those agencies.

It is the OCFO recommendation of the OCFO that the Medicaid Reform
Office be established immediately to begin transformational reengineering
of the billing/documentation processes.

Other Current Spending Pressures

The remaining $1826.6 million in current spending pressures stem from
external judgments and settlements: $11.1 million stemming from past
reductions-in-force (RIF)s – ($10 million from 1999 RIFs at the
University of the District of Columbia and $1.1 million from recent RIFs
at the Department of Corrections – and $7.5 million from court
judgments.

Proposed Gap Closing Measures

The OCFO estimates that over 80 percent of the $75 million revenue
shortfall will have to be met with savings from District-wide adherence to
a very strict expenditure budget for the remainder of this fiscal year. We
are considering any possible short-term initiatives to raise revenue.
However, because we are now nine 9 months into the fiscal year, few
revenue strategies are available, and our focus must be on expenditures.
These would include freezes on hiring, overtime, and spending from
non-personal services, as well as and converting eligible "O"
type revenues accounts into unrestricted local funds.

These will be difficult budget measures for the final three months of
the fiscal year. If agencies voluntarily forego expenditures that are
either optional or can be delayed, the hardship may be reduced, and these
measures should be strongly encouraged. With decisive action, we expect
that the problem can be handled without adding personal hardships for
employees such as furlough days or reductions-in-force.

The financial viability of the District is paramount. Early next week
the OCFO will present the budget options that would ensure that viability
through FY 2002. The concern obviously extends to FY 2003 and later years.
In August, the OCFO will present the Mayor and Council budget options to
continue the District’s financial viability into FY 2003.

I will keep you updated as the fiscal year progresses. In the meantime
I look forward to your support in bringing expenditures in line with
current forecasts of revenue generation in FY 2002.

Cc: John Koskinen, City Administrator
Bert Molina, Deputy Chief Financial Officer, Office of Budget and Planning
Artie Blitzstein, Budget Director, Council of the District of Columbia

1. This includes tax revenue, non-tax
local source revenue, and lottery revenue. It does not include federal
payments for support of federal programs; grant, private and other
revenue; or any transfers from accumulated fund balances.

3. State Revenue Report #48, June 2002,
Fiscal Studies Program, The Nelson A. Rockefeller Institute of Government,
State University of New York.

4. State Fiscal Update, June 2002, June
4, 2002, National Conference of State Legislatures, Federation of Tax
Administrators, national Association of State Budget Officers, Nelson A.
Rockefeller Institute of Government.